Purchasing Power

What it is:

Purchasing power is a phrase to describe the quantity of goods or services that a dollar can buy. A decrease in purchasing power is called inflation.

How it works (Example):

Let's assume $1 bought 1.50 gallons of gas in 1987. Today, $1 buys about half a gallon. This is an example of the change in the purchasing power of the American dollar.

Two general theories explain decreases in purchasing power. The first, the demand-pull theory, says prices increase when demand for goods and services exceeds their supply. The second, the cost-push theory, says that companies create inflation when they raise their prices to cover higher supply prices and maintain profit margins.

The Bureau of Labor Statistics calculates and publishes the Consumer Price Index (CPI), which measures decreases in purchasing power. The CPI measures the change in the retail prices of approximately 80,000 specific goods and services, called the market basket. The BLS calculates the CPI by comparing the cost of the market basket to the same basket in the starting year (usually 1982-1984). To do this, the BLS sets the average price of the market basket during the years 1982, 1983, and 1984 to equal 100. Then in every subsequent period, the BLS calculates price changes in relation to that number. A CPI of 120, for example, means that prices are 20% higher than they were in the base period.

Purchasing power has a significant effect on investment returns and decisions. For example, let’s assume you invest $1,000 in a one-year XYZ Company bond. If the bond yields 5%, then at the end of the year you will collect $1,050. Your 5% return may not be as good as it looks, however, if your purchasing power decreases 4% during the year. Your real return is actually 1%. Some securities, such as Treasury Inflation-Protected Securities (TIPS), tie their principal and coupon payments to changes in purchasing power (the CPI) in order to compensate the investor for inflation.

Why it Matters:

Changes in purchasing power directly or indirectly affect nearly every financial decision, from consumer choices to lending rates, and from asset allocation to stock prices. Purchasing power also offers important clues about the state of an economy. Most economists agree, for example, that moderate decreases in purchasing power are a sign of a growing economy and that increases in purchasing power are a sign of stagnation.

Purchasing power can also distort a company’s financial performance. For example, a company that reports high revenue growth during a period of rising inflation could be misleading shareholders if those revenues were the result of inflationary pressure rather than managerial skill. For this reason, many analysts use inflation information to “deflate” or adjust certain financial measures so they can compare them accurately over time. Inflation can also influence a company’s choices in accounting methods. For example, in a rising cost environment, a company may be tempted to use the FIFOinventory method in order to increase paper profits; in a falling cost environment, LIFO may be better.

Purchasing power also affects securities values by way of the discount rate. When inflation is high or rising, the future dividends or interest payments from an investment are worth less. In broad terms, the higher inflation goes, the higher the discount rate goes, and the lower the value of the security goes. The reverse is also true.

Because the Federal Reserve’s job is to maintain long-term economic prosperity through the execution of monetary policy, it takes a keen interest in purchasing power when deciding whether to raise or lower the federal funds rate. This is one reason some analysts consider inflation a measure of the effectiveness of certain government policies.

Contracts and other obligations involving payments over time often consider purchasing power. For example, many labor contracts tie wage adjustments to changes in the CPI, as do some alimony, child support, rent, royalty, and other obligations affected by changes in purchasing power. People living off fixed incomes are particularly affected by changes in purchasing power, and this is why the government usually adjusts social security checks and food stamps as well as the wages of federal employees and members of the military on a regular basis.

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